High Yield Bonds

Updated on April 9, 2024
Article byWallstreetmojo Team
Edited byAshish Kumar Srivastav
Reviewed byDheeraj Vaidya, CFA, FRM

What Are High Yield Bonds?

High yield bonds are bonds issued by a corporation that has been assigned below the investment grade threshold by popular credit rating agencies such as below “BBB” from Standard & Poor and below “Baa” from Moody’s due to additional credit risks involved in interest and principal repayment. However, to compensate for higher default risks, these bonds offer attractive returns to investors.

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Often referred to as junk bonds, they are more likely to default in comparison to investment-grade bonds and are more volatile in nature. Since these factors attract more risk for investors, the rate of return is generally higher as well. The issuers of corporate high yield bonds are generally start-ups or companies that are capital intensive with a high debt ratio.

Key Takeaways

  • High-yield bonds, also known as junk bonds, have below-investment-grade credit ratings and carry a higher risk of default. However, they offer higher yields to compensate investors for the increased risk.
  • Companies typically issue high-yield bonds with weaker credit profiles, higher debt levels, or facing significant business challenges. They provide an opportunity for higher returns compared to investment-grade bonds but come with higher credit risk.
  • High-yield bonds have a higher default risk, requiring thorough credit analysis and careful selection of issuers with strong financial health and prospects for timely payments.

High Yield Bonds Explained

High yield bonds are corporate debt securities that usually provide a more attractive interest rate in comparison to investment-grade bonds. These bonds are also more volatile in nature and the risk of default is very much present.

A major attraction of high yield bonds is that it seems to generate both equity-like returns with bond type risks. Studies have shown High yield market has a negative correlationNegative CorrelationA negative correlation is an effective relationship between two variables in which the values of the dependent and independent variables move in opposite directions. For example, when an independent variable increases, the dependent variable decreases, and vice versa.read more with the government bond market and low positive to zero with equities and investment-grade bonds.

The issuers of these types of bonds are either start-ups or capital-intensive corporates with a significantly high debt ratio. Since there are high chances of these bonds defaulting and low ratings from esteemed companies, they are also referred to as junk bonds. These non-investment grade bonds are split into two major categories- fallen angels and rising stars.

For investors who want to do not want to take the risk of default can mitigate the risk to an extent by investing in a basket of bonds through high yield bonds ETFs.

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Features

Let us understand the features of a corporate high yield bond. These factors are quite different from investment-grade bonds and an investor must be thorough with these features before investing their money into this asset class. Let us understand these points from the explanation below.

Types

Let us understand the different types of junk bonds that might feature in a high yield bonds ETF or bonds of this nature in singularity. This will give us a detailed understanding of the concept and related factors.

Who are the Investors In Them?

Since most retail investors would not want to expose themselves to so much risk in a debt instrument as it is generally looked upon as a safe investment in comparison to equity or cryptocurrency. Therefore, it is vital to understand who are the typical investors in corporate high yield bonds to understand the concept fully.

How To Buy?

While researching before investing in this asset class, the prospectus of the issuer can give clarity with regard to their plan and the purpose for which they are raising these funds. However, there are two ways in which an investor can go ahead with their plans of investing in corporate high yield bonds. Let us understand both of them through the discussion below.

  • Broker-Dealers: Investors can choose to buy these bonds directly from brokers or deals who shall charge a specific fee for helping them gain access to investing in the bond.
  • ETFs: ETFs are a basket of bonds just like mutual funds for equity. Here, a fund manager shall be in charge of choosing the bonds that shall be invested through the portfolio.
  • Therefore, based on the risk appetite, time frame, and requirement for control, an investor can choose any of the two options to buy these bonds.

Who are the Borrowers?

High yield financing has played a prominent role in certain sectors such as technology, media, energy, and IT infrastructure. Companies in these sectors have a high debt burden relative to their earnings and cash flow. Some are startup companiesStartup CompaniesA startup can be expressed as a business in its initial phases, searching for a practical and scalable model. Often, these companies launch and market a unique idea, product, or service that in some way offers fresh benefits to the society. Reliable models aid in the rapid growth of the business.read more or well-established companies restructuringRestructuringRestructuring is defined as actions an organization takes when facing difficulties due to wrong management decisions or changes in demographic conditions. Therefore, tries to align its business with the current profitable trend by a) restructuring its finances by debt issuance/closures, issuance of new equities, selling assets, or b) organizational restructuring, which includes shifting locations, layoffs, etc.read more, or high yield loans are used to finance the leveraged buyoutLeveraged BuyoutLBO (Leveraged Buyout) analysis helps in determining the maximum value that a financial buyer could pay for the target company and the amount of debt that needs to be raised along with financial considerations like the present and future free cash flows of the target company, equity investors required hurdle rates and interest rates, financing structure and banking agreements that lenders require.read more, refinancing existing loans, acquisitionAcquisitionAcquisition refers to the strategic move of one company buying another company by acquiring major stakes of the firm. Usually, companies acquire an existing business to share its customer base, operations and market presence. It is one of the popular ways of business expansion.read more, takeovers, etc.

Indexes

The market index for fallen angels or rising stars indicates the overall movement of the market and also give investors a clearer picture in terms of the right time to invest into the market in the form of singular such bonds or through high yield bonds ETF. Let us understand the indexes through the points below.

  • Standard & poor high yield corporate bond index
  • CSFB high yield II index
  • Bloomberg USD high yield corporate-based index
  • FINRA Bloomberg active high yield US corporate bond index
  • Barclays high yield index
  • Citigroup US high yield market index

Advantages

Let us understand the advantages of high yield bonds ETF and investing in a singular bond directly from a broker-dealer. This will give us a deep dive into the concept and its intricacies.

Disadvantages

Despite the various advantages mentioned above, there are a few factors that prove to be a disadvantage for investors. Let us understand the disadvantages of investing in corporate high yield bonds through the explanation below.

Frequently Asked Questions (FAQs)

1. What are the key factors to consider when investing in high-yield bonds?

When investing in high-yield bonds, there are several key factors to consider. Firstly, assessing the issuer’s creditworthiness is important, as high-yield bonds typically come with a higher risk of default. In addition, analyzing the issuer’s financial health, industry dynamics, and management quality can help evaluate the risk-reward profile.

2. Why is the yield spread important for high-yield bonds?

The yield spread is significant for high-yield bonds because it reflects investors’ compensation for taking on the higher credit risk associated with these bonds. The yield spread represents the additional yield that high-yield bonds offer compared to safer investments, such as government bonds or investment-grade corporate bonds. 

3. What are high-yield bonds vs low-yield bonds?            

High-yield bonds, also known as junk bonds, have lower credit ratings and a higher default risk than investment-grade bonds. These bonds offer higher yields to compensate investors for taking on the increased credit risk. On the other hand, low-yield bonds refer to investment-grade bonds with higher credit ratings and lower risk of default. Financially stable companies issue these bonds with good credit quality.

This has been a guide to What are High Yield Bonds. Here we explain its index, how to buy, types, advantages, and disadvantages in detail. You can learn more about from the following articles –

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